Mexico, Canada put your stock portfolio on the map

Good neighbors make for good investments compared to U.S. market

SAN FRANCISCO (MarketWatch) — Investors looking for direction from the U.S. stock market may want to gaze north and south — to Canada and Mexico — for cheaper and better opportunities.

As two of the three top U.S. trading partners other than China, Canada and Mexico stand to benefit from a U.S. economic recovery as well as their own.

But Canada’s resource-heavy market and corruption and violence in Mexico are major risks.

“Both Canada and Mexico represent opportunity and peril,” said Scott Barclay, a financial writer and editor of e-newsletter The Investing Opinion.

“An investor needs to be confident that oil will rise in price to consider Canada a good investment,” he said. “Mexico is actually more diverse. However, government corruption presents headline risk.”

Nonetheless, some analysts tout the merits of these two neighbors for patient investors.

“Economic growth is expected to be a little stronger here in the U.S. than in Canada over the next couple of years,” said Nicholas Kaiser, manager of Sextant International Fund
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But “with 70% of Canadian exports hitting U.S. markets, it bodes well for Canadian industry.”

Mexico’s economy, “closely tied to the outlook for the U.S. and Mexican growth, looks to be improving with industrial, trade and consumer activity benefitting from the recent improvement in growth in the U.S.,” said Allan Conway, head of emerging market equities at Schroders PLC. U.S. GDP grew 1.7% in 2011 over 2010, which in turn saw growth of 3% from the previous year.

Last year, the economies of Mexico and Canada both grew faster than the U.S.

Mexico GDP growth was 3.9% in 2011, though the nation’s central bank expects to see 3% growth this year. At an annualized rate, real GDP in Canada expanded 1.8% in the fourth quarter of last year, and the Bank of Canada forecasts growth of 2.4% for this year.

Mexico’s risks, rewards

In Mexico, investors will need to weigh opportunity tied to the U.S., the country’s top trading partner, against risks associated with ongoing corruption and violence — most recently bribery allegations involving Wal-Mart de Mexico, (WALMEXV), the largest foreign unit of Wal-Mart Stores Inc.
WMT, -1.58%Read more on Wal-Mart de Mexico.

“Political risk, corruption and drug-related violence is a big concern for the Mexican economy and the stock market,” said Moe Ansari of Compak Asset Management in Newport Beach, Calif.

At the same time, he added, these risks “are priced into equity prices in terms of lower GDP and [earnings-per-share] growth that could be achieved in Mexico.”

A presidential election slated for July adds uncertainty to Mexico’s outlook.

The nation has “strong potential for upside depending on the capability and willingness of the next government to implement much-needed structural reforms that would improve the competitiveness of the national economy,” said Clinton Carter, associate vice president for Latin America, and Antonio Martinez, Latin America analyst, at Frontier Strategy Group.

The current presidential front-runner is Enrique Peña Nieto, a former governor with the Institutional Revolutionary Party. Carter and Martinez said that if elected, Nieto may open the oil and natural gas sectors to more foreign investment, “which would generate considerable opportunities for local construction and construction equipment and oil and gas services firms.”

Corporación Geo (GEOB) and Urbi Desarrollos Urbanos (URBI) are among the local construction firms.

Two other potential bright spots are retail and high-value-added manufacturing, Carter and Martinez said, with Organización Soriana (SORIANAB) among Mexico’s leading retail chains. Manufacturers, the strategists added, benefit from “higher wages in Asia, which is shifting the global supply chain back towards Mexico.”

At the same time, Mexico’s stock market is “structurally more defensive than many markets in the global emerging markets (GEMs) with consumer staples and telecom companies constituting over 60% of the index,” Schroders’ Conway said, which can lend support “in times of elevated global market uncertainty.”

Yet compared to GEMs, valuations in the Mexican market are expensive, with the market trading at 14.6 times earnings versus the global emerging market average of 10.3 times, according to Conway.

“By most valuation measures, the Mexican market is not cheap but given the demographic and economic growth trends, we expect EPS growth to continue,” Compak’s Ansari noted.

Resourceful Canada

The U.S. neighbor to the north may be a better choice — if investors choose wisely among this resource-heavy market.

Based on estimates for operating earnings growth for the S&P/TSX Composite Index($ISPTX) of about 10% and 15% in 2012 and 2013, respectively, “the outlook remains solid,” said Tim Caulfield, director of equity research at Bissett Investment Management, citing data from TD Securities.

That said, he added, “with a significant contribution coming from the commodity-price driven resource sectors ... this fundamental support from strong earnings growth is inherently uncertain.”

Canada’s central bank raised its own GDP growth forecast to 2.4% from 2% for this year — “That is a healthy economy and we find their markets more attractive than ours,” said Malcolm Gissen, co-manager of Encompass Fund
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“It is a stock picker’s market so one has to choose sectors and companies carefully, especially since their economy is resource based,” he said.

Indeed, the difference between U.S. and Canadian equity markets is clear in the concentration of materials, energy and financials constituents, said Kaiser, the Sextant International Fund manager. Those three areas account for 76% of the S&P/TSX Composite Index, he noted, versus 29% of the U.S.-benchmark Standard & Poor’s 500-stock index.
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“Canada is most heavily weighted in the resource sectors (energy and mining) that have lagged behind in recent months with crude oil stagnant, base metals prices like copper falling, and precious metals consolidating last fall’s big losses,” said Colin Cieszynski, market analyst at CMC Markets. These sectors are largely to blame for the Canadian market’s underperformance relative to the U.S., he said.

“The basic story is that the TSX is dominated by resource producers and financials,” said Paul Ashworth, chief U.S. economist at Capital Economics. “The economy’s performance has little to do with it.”

Among financials, “Canadian banks are struggling to boost revenues when demand for mortgages is slowing as the overheating housing market cools,” he added.

Ashworth said he generally has a negative view on commodities and that “slowing global demand will knock prices,” while the Canadian housing market is “a bubble close to bursting, which would presumably have a negative impact on Canadian bank revenues.

“The implications for the TSX are pretty clear,” he noted.

But Kaiser, who is also portfolio manager of the Amana Funds, which includes Amana Growth Fund
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is optimistic about resource stocks.

His favored Canadian resource plays include Barrick Gold Corp. (ABX), Potash of Saskatchewan Inc. (POT) and Encana Corp. (ECA). He also likes telecoms Telus Corp. (T) and BCE Inc. (BCE), along with railroads Canadian National Railway Co. (CNR) and Canadian Pacific Railway Ltd. (CP).

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